II-VI Is A Powerful Choice In Multiple Secular Growth Trends

Summary

• II-VI has built a remarkably robust moat and is massively investing in strong secular growth trends.
• The street consensus anticipates 16.11% FCF and 13.34% EBIT CAGR over the next 5 years.
• The acquisition of Coherent is fully funded and the company has a sustainable and realistic deleveraging plan.
• An advantageous risk-reward profile is limiting the downside while my valuation model prices the stock at $89.73 with 44% upside potential.
• The company was awarded twice from Apple’s Advanced Manufacturing Fund totaling $800M and underscoring the relevance of its products and technologies.

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Investment thesis

II-VI Incorporated (IIVI) has aggressively expanded its leadership position in its most relevant markets, while maintaining a relatively healthy balance sheet and securing its market share in secular growth trends. The company is anticipated to close the acquisition of Coherent in the short term, as it waits for the Chinese antitrust regulator to give its consent. II-VI has an outstanding growth potential in its end-markets, such as communication with the adoption of 5G and increasingly demanding technology in data centers, in the automotive industry with the emergence of self-driving cars and electric vehicles, or in the consumer electronics market, with augmented and virtual reality applications as well as 3D sensing. The company is investing $1B over the next 10 years in the next generation semiconductor material that can significantly reduce power losses and enable higher power density, voltages, temperatures, and frequencies while reducing heat dissipation and necessary size of the components. A relatively high short interest has built up over the past years, with bets against the company’s ability to achieve its targets; instead, the company has consistently delivered strong results and is successfully integrating the recent acquisitions. The actual share price has a remarkable upside potential of 44%, with a price target of $89.73.

A quick look at II-VI

II-VI is an American company that operates in the electronic components industry, and develops, manufactures, and markets optoelectronic components, engineered materials, and devices worldwide. Its business is divided in two segments, photonic solutions and compound semiconductors. The photonic solutions segment offers optics, lasers, optoelectronic modules, transceivers, advanced components for telecom networks and data centers, wavelength selective switches, and crystal materials. The compound semiconductors segment provides optical, electro-optical, and infrared optical components and materials used in high-power CO2 lasers, fiber-lasers, and direct diode lasers; high-precision optical assemblies, semiconductor lasers and detectors for optical interconnects and sensing applications; engineered materials for thermoelectric, ceramics, and silicon carbide (SiC) applications; as well as compound semiconductor epitaxial wafers for applications in optical and wireless communication. It serves customers in the communication, industrial, aerospace and defense, semiconductor capital equipment, life sciences, consumer electronics, and automotive markets. The company was founded in 1971, is headquartered in Saxonburg, Pennsylvania, and employs over 22,000 employees in over 18 countries. Its most important geographical region is North America, followed by Hong Kong, China, Germany, and Japan.

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The company saw its revenue growing in its most important geographic regions over the past 5 years, recording a growth of 33.70% Compound Annual Growth Rate (CAGR), with sales in the US growing at 61.82% CAGR.

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On November 9, 2018, II-VI announced the acquisition of Finisar Corporation in a deal valued at $3.2B, finalizing the takeover by September 24, 2019, and forming a global leader in the highly growing markets of 5G, 3D sensing, cloud computing, electric and autonomous vehicles, and advanced microelectronics manufacturing. The deal allowed II-VI to aggressively expand its capacities in the 3D sensing market, especially in the production of vertical cavity surface-emitting lasers (VCSELs) for use in 3D sensing applications like facial security scanning used in smartphones and other devices. Apple awarded II-VI with $410M in May 2021, after the company already received funding of $390M from Apple’s Advanced Manufacturing Fund in 2017, an important aspect to consider in the change in sourcing for Apple and its Face-ID and Time of Flight (TOF) Light Detection and Ranging (LiDAR) technology.

On March 25, 2021, the company announced the acquisition of Coherent (NASDAQ:NYSE:COHR), a global leading provider of lasers, laser-based technologies and laser-based system solutions, in a deal valued at approximately $6.88B. The deal has yet to be accepted by the Chinese antitrust regulator, who delayed the decision because of insufficient remedies on the market. II-VI expects the combined company to have annual revenues of approximately $4.1B initially, with a combined addressable market of approximately $25B, projected $250M of run-rate cost synergies achieved within the 36 months after the deal closing, and that the deal will be accretive to non-GAAP earnings per share in the second year following close.

II-VI

Although the company’s balance sheet will significantly be impacted by the acquisition of Coherent, II-VI projects a rapid deleveraging in the two years after the closing, from strong EBITDA and cash flow generation of the combined company.

An insight into the industry

It is quite difficult to compare II-VI to direct competitors or similar peers, since the company operates in many fields and offers such a large spectrum of products. The company reported an increasing gross margin, accelerating from 26.86% CAGR over the past 5 years to 34.76% CAGR over the past 3 years and standing at 39.40% Trailing Twelve Months (TTM). While its actual gross margin is below the average of the analyzed peers, it’s important to note that none of them had such significant growth over the past 3-5 years, and some even saw their gross margin decelerating.

In terms of operating profitability, II-VI reported a significant improvement of 28.41% CAGR over the past 5 years, growing to 40.49% CAGR over the past 3 years, and standing at 12.73% TTM. Although some of its peers reported a higher profitability in the last 12 months, II-VI recorded the greatest acceleration of its operating margin over the last 3 years.

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In terms of capital allocation efficiency, the company could not achieve the high performance of some of its peers, with only ams-OSRAM (OTCPK:AMSSY) or (OTCPK:AUKUF) reporting even lower metrics, II-VI reported a Return on Invested Capital (ROIC) of 8.16% in the past 12 months, while the peers’ average stood at 14.77%. I consider this metric to be a very important element when pondering an investment decision; a company must be able to consistently create value to be a sustainable investment. Companies such as Lumentum (NASDAQ:LITE) or IPG Photonics (NASDAQ:IPGP) which reported a significant negative net debt, could increase their capital allocation by investing their cash positions. Coherent being more efficient in those terms, once the two companies are fully integrated, the capital allocation efficiency could potentially increase as a consequence of the mentioned cost synergies and a better capital management. In my article ams-OSRAM Is A Victim Of Its Success, I give more details on this company which is still in the process of integrating the OSRAM acquisition, a step I personally criticized, as the timing and the conditions at which that takeover was executed, was quite inappropriate and led to a significant value destruction for ams’ shareholders.

Investments in Research and Development (R&D) are of primary importance for companies in the semiconductor and electronic components industry, and II-VI is spending a relatively fair amount of 11.27% when compared to the average of its competitors, slightly increasing its spending from about 10.39% on average in the past 6 years.

The company reported relatively high leverage of 3.36, a metric which will significantly increase with the takeover of Coherent, but as mentioned before, the combined company will likely be able to reduce its debt exposure in the two following years, with a target of 2.5 gross leverage.

Considering the stock performance of the past 5 years, II-VI performed better than most of the analyzed peers, with only Broadcom (NASDAQ:AVGO) performing even better. Without surprise, ams-OSRAM is the worst performer of the group, while Coherent underperformed the group for a considerable time.

Author, using Seeking Alpha

II-VI underperformed significantly the First Trust Nasdaq Semiconductor ETF (NASDAQ:FTXL) in the last two years, while showing some sporadic periods of relative strength; when compared to the S&P500 instead, the company greatly outperformed the index.

Author, using Seeking Alpha

All relevant end-markets of the company are anticipated to expand at a sustained rate over the next few years, and the company announced its intention to invest $1B over the next 10 years in the SiC segment, which is projected to grow at 50% CAGR between 2020 and 2030. The investments are aimed to position the company as a vertically integrated SiC power electronics technology leader, offering high-power and high-frequency semiconductor modules and devices that operate well beyond the capabilities of either silicon or gallium arsenide devices. The company already reported strong growth from revenue of SiC products in Q2 2022, with 11% growth both sequentially and on a year-over-year (YoY) basis, confirming this trend in its Q3, where the company reported 13% YoY growth in its industrial segment, fueled by its SiC solutions.

II-VI

Valuation

To determine the actual fair value for II-VI’s stock price, I rely on the following Discounted Cash Flow (DCF) model, which extends over a forecast period of 5 years with 3 different sets of assumptions ranging from a more conservative to a more optimistic scenario, based on the metrics determining the Weighted Average Cost of Capital (WACC) and the terminal value. As forecasted by the street consensus, the company is anticipated to generate consistent, solid 16.11% Free Cash Flow (FCF) CAGR over the coming 5 years, while its revenue is forecasted to grow slower, at 8.59% CAGR. Considering the previously discussed growth in its most relevant end-markets and pondering those estimations with the company’s average revenue share by end-market, gives an average growth rate of 11.45% CAGR through 2026, that underscores the rather cautious forecast in this DCF modeling.

Author, using data from S&P Capital IQ

The valuation takes into account a tighter monetary policy, which will undeniably be a reality in many economies worldwide in the coming years and lead to a higher weighted average cost of capital.

Author

I compute my opinion in terms of likelihood for the three different scenarios, and I, therefore, consider the stock to be considerably undervalued with a weighted average price target with 44% upside potential at $89.73.

Risk discussion

The pending acquisition of Coherent is facing a delay mostly due to the Chinese regulator’s reluctance to give its consent. However, the two companies are reportedly implementing specific market remedies, which could possibly satisfy the Chinese antitrust regulator’s requests, and the deal could be approved in the coming weeks. The transaction also bears risks in terms of integration of Coherent, and the successful achievement of II-VI expected targets.

II-VI sales are diversified in many industries and the company is targeting strong secular growth vectors with advanced R&D and production capacity. With the recent acquisitions and the company’s strategy to focus on vertical integration in the production of relevant technologies, II-VI has created a robust moat and is characterized by a relatively low risk profile in its business. As we will see in the next section, this risk mitigation is also evidenced in the recent stock performance and serves as strong support for the downside risk.

Market timing

The stock reached its All-Time-High (ATH) at $100.44 on February 11, 2021, after a long rally since the Covid-19 pandemic low at $19 on March 12, 2020. The stock successively had a period in which it underperformed the NASDAQ Composite, by retracing until $54.35 and since then showing significant relative strength while many companies in the technology sector lost massively in value. From a technical analysis point of view, the stock is now in a side movement, between $75 and $55-56 on the lower end, a great setup for momentum and swing traders. The market is waiting for further positive catalysts, while the strong moat and the potential offered through the recent acquisitions, give the stock a strong support, reducing the risk of further losses.

Author, using TradingView

II-VI can count on significant institutional support among its shareholders with 98.76% of the outstanding shares owned by institutions, and a relatively high short interest of 19.88% and over 15 days to cover. The street consensus given by 16 analysts prices the share on average at $83.88 with a buy rating, with the lowest estimation at $65 and the highest at $121. The Seeking Alpha Quant Rating instead qualifies the stock consistently as a hold position. In my opinion, the stock has shown to be less affected by the recent market turmoil and has formed a quite strong bottom. However, the upside is limited by a very strong resistance level at $75, which is likely also close to the breakeven for many short sellers, who are probably betting on the failure of the Coherent acquisition or on a similar scenario as happened to ams-OSRAM in the past years, when the company lost significant revenue from its main customer Apple (NASDAQ:AAPL); and, as I explained in this article, it’s very likely that II-VI gained the supplier-slot in Apple’s 3D sensing technology. Technically the stock is, in my opinion, in a comfortable setup for both long-term investors as well as more short-term traders, which can set their stop-loss in order to limit the downside risk. To break out of its lateral channel, the stock will need a major positive catalyst or a consistently positive trend in the general market.

The bottom line

Investing in a technology company can be associated with a higher risk-profile, and not all companies in this sector have a strong moat as II-VI has built over the past years. The company has an undeniably large offering of high-demand products and technologies, with strong R&D and production capacities, and cost-advantages given by its focus on a vertical integrated structure. Although the past few years were challenging in terms of consolidating important acquisitions, II-VI has until now achieved its aggressive expansion strategy and is forming an outstanding market leader in crucial, future-oriented, technologies and materials. Given the relatively low downside risk and the massive potential in both market opportunities and stock price gains, I value the stock as a buy with 44% upside potential and a price target seen at $89.73.

Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.